The fiscal cliff: Will Obama, Congress cut budget deal?

WASHINGTON -- Five people will gather Friday inside the White House tobegin making decisions that could affect the pocketbooks of 315 millionAmericans.

When President Obama sits down with the Republican andDemocratic leaders of Congress, only 46 days will remain before thenation risks plunging over the "fiscal cliff" - a pileup of scheduledtax increases and spending cuts that threaten to drain $560 billion outof the economy next year and derail the recovery.

Itwill be high-stakes poker, holding the promise of great rewards for aneconomic rebound if Washington succeeds and the peril of anotherrecession if it fails.

Promise or peril, some Americans are goingto feel the pinch. Should Obama get his way, those with annual incomesabove $250,000 will face higher tax bills. If Republicans come out ontop, tax rates and defense spending will remain the same, but socialprograms will face budget cuts.

A compromise portends discomfort,most likely in the form of reduced paychecks, jobless benefits andbusiness tax breaks. And a stalemate means higher taxes and reducedfederal spending across the board, including at the Pentagon.

Thatlast scenario has Main Street and Wall Street worried. "We think thefiscal cliff would trigger an avoidable and unnecessary recession," saysDavid Riley, head of Fitch Rating's sovereign-debt rating committee,comparing a decision to go over the cliff to a "kamikaze"deficit-cutting mission. "It would impose real costs on real people."

Conversely,a sensible solution to avoid the fiscal cliff and put the nation'sfinances on a more sustainable path offers lawmakers the chance to latchon to a budding economic recovery. An improving housing market and ablossoming oil and gas market already have economists projecting thatthe U.S. could add 12 million jobs over four years if policymakers don'tmess things up.

"Main Street will come alive. All the lights willbe bright, and the economy of this nation will be the envy of theworld," says Republican Judd Gregg, former Senate Budget Committeechairman. "We are ready for boom times in the nation if we could justget our fiscal policy under control."

Now that the election isover, and the same cast of characters is left watching the store, thewhole world is waiting to see what they do. Businesses fearing anotherrecession are waiting to hire. Workers are wondering if they'll lose a2-year-long reduction in the payroll taxes that fund Social Security - abreak worth $20 a week to the median working family. Domestic andinternational financial markets are waiting to see if a U.S. recessionwould further damage a global economy already weakened by Europeanausterity and a marked slowdown in China.

Americans are hopefulbut not confident. Two in three of those surveyed in a USA TODAY/GallupPoll during the past week want the two sides to split theirdifferences, 45% want an equal division between tax increases andspending cuts, 30% want mostly spending cuts and only 10% oppose taxincreases altogether. One in three expect negotiations to fail and theeconomy to tumble over the fiscal cliff.

The cliff is alreadyholding back the recovery, as companies keep capital on the sidelines infretful anticipation. David Cote, CEO of Honeywell and a member of thecommission that recommended nearly $4 trillion in tax increases andspending cuts in 2010, sees it in reduced hiring. Since spring, he hasreplaced only 25% of the workers who left Honeywell, a decision that hascost about 600 jobs so far.

"The last thing you want is to hire a lot of people and then have tolay them off," Cote says, explaining why the other 75% of people wholeave Honeywell are not being replaced. "Capital is a coward."

Democratscheered by Obama's re-election and small gains for their party in theSenate and House believe they have the upperhand in negotiations,particularly on taxing higher-income Americans. Unions and liberalgroups have seized on that advantage with a grass-roots and advertisingcampaign calling for higher taxes on the wealthy and no reductions inbenefits for Social Security, Medicare and Medicaid.

"The gamechanged (election) night," says Mary Kay Henry, president of the ServiceEmployees International Union, one of several labor leaders to meetwith Obama at the White House Tuesday. "We are going to call upon ourgovernment to respect the will of the voters."

GOP leaders,including the two who will meet with Obama on Friday - House SpeakerJohn Boehner and Senate Minority Leader Mitch McConnell - want to holdthe line on income tax rates and force bigger reductions in benefitprograms.

"The president needs to lead," McConnell said Tuesday."And that means offering a concrete plan that takes into account thefact that half the Congress opposes tax hikes - not because we'reselfish or stubborn, but because we know it's the wrong thing to do,because we know it will hurt the economy."

In the middle arefiscal watchdogs, business executives and young Millennials who want adeal, even if it includes tough tax hikes and spending cuts needed totrim annual $1 trillion deficits and control a $16.2 trillion debt. Adozen CEOs get their White House session with Obama today.

"Wethink the fiscal cliff is the best opportunity Congress has had indecades to solve some of the major economic and fiscal problems thiscountry faces," says Jim Kessler, senior vice president for policy atThird Way, a moderate Democratic think tank. "This is a now-or-nevermoment that we should embrace."

Scenario 1

A hard landing

As Obama demands higher tax rates for the wealthiest and Republicansinsist that won't happen, the two sides could go briefly past Jan. 1without a deal on most of the expiring tax breaks. That could lead to aneconomic slowdown and joblessness heading toward 10%. T. Rowe Pricechief economist Alan Levenson says Obama can reduce the impact for ashort time by ordering the Internal Revenue Service to collect 2013withholding taxes at 2012 rates.

If Washington fails and all ofthe fiscal cliff's tax and spending measures stay in effect, the economywould fall into a mild recession in the first half of the year beforeresuming its weak growth rate in the second, the Congressional BudgetOffice estimated last week.

Unemployment, now 7.9%, would rise to 9.1% by the end of 2013, it said.

It'sunlikely that the downturn, while expected to be short, would be asnasty as the 2008 financial crisis. Financial markets think CBO'sforecast is too optimistic, because the economy is only growing a littlefaster than 2% this year and the cuts could subtract up to 3.6% or moreof total economic activity. The International Monetary Fund says"global spillovers would be amplified through negative confidenceeffects, including, for example, a global drop in stock prices."

Fitch,one of the bond-rating services whose threats to cut the U.S. bondrating is driving pressure to make a deal, says unemployment could top10%. Both Fitch and Moody's Investors Service say failure to reach even atemporary deal likely would result in a downgrade. The NationalAssociation of Manufacturers says going over the cliff could forfeit 6million jobs and a 10% loss in household income.

"It could be a lot worse than people expect," Cote says.

Thenon-partisan Tax Policy Center estimates that toppling over the cliffwould cost about $3,500 per U.S. household. A typical middle-incomefamily would see taxes rise by about $2,000. Those in the top 1% wouldpay an additional $120,000, while the average low-income household wouldpay about $400 more.

Another potential downside for taxpayers:Congress has to decide whether to let the payroll tax cut and extendedjobless benefits expire, since both were tied to the recession.Eliminating the payroll tax cut and unemployment benefits could cost theeconomy 800,000 jobs, CBO says. The Wall Street firm BlackRockestimates it would cut the economy's 2% growth rate in half.

Ifextended unemployment insurance expires on schedule, 2.1 millionAmericans would see benefits stop immediately at the end of the year - a"human cliff," says Rep. Sander Levin, D-Mich., top Democrat on theHouse Ways and Means Committee.

And if lawmakers don't agree toprevent the alternative minimum tax (AMT) from hitting millions ofupper-middle-income taxpayers, the IRS might have to delay processingtens of millions of returns in January and February.

Automaticspending cuts would trim about $55 billion, or nearly 10%, from thedefense budget next year. While Obama has exempted the armed forces frompersonnel or pay cuts, more than 100,000 civilian employees could losetheir jobs next spring. The defense industry would be forced todownsize, reducing employment among defense contractors gradually,according to the Center for Strategic and Budgetary Assessment. Therewould be no base closures.

The cuts would cause an equally largereduction in domestic programs, ranging from air-traffic control toagriculture. That could threaten nearly 25,000 Homeland Security jobs,45,000 cancer screenings for women and 100,000 Head Start placements,according to House Appropriations Committee Democrats. Medicare would becut by 2%.

Scenario 2

A soft landing

This most likely scenario includes extending most if not all of theBush tax cuts and making a down payment on spending cuts. The payrolltax cut and extended jobless benefits could expire; the AMT could bepatched. A timetable for actions on spending and income taxes would becreated.

Leading up to Friday's initial White House meeting, thepublic appears to be siding with Obama on taxes. Surveys of voters takenon Election Day showed 47% of Americans favor raising individual incometaxes on the wealthiest, while 35% want to keep taxes where they are.

Boehnerand other Republicans insist that Obama's proposal to push the topincome tax rate back up from 35% to 39.6%, where it was under PresidentClinton, would hurt small-business "job creators" who pay personal taxrates rather than corporate rates. Boehner says it would cost 700,000jobs.

About three-fourths of U.S. manufacturers, mostly smallones, use personal rates, according to the National Association ofManufacturers. Their average taxable income: $384,000. Under Obama'sproposal, a sole proprietor matching their profile would pay about$6,750 more per year.

Restoring payroll taxes to their 2010 levelwould raise about $115 billion, and ending the extended unemploymentinsurance benefits would save another $40 billion. Along with spendingcuts chosen by negotiators rather than leveled across the board, aninterim deal could produce "a down payment of $300 billion to $500billion to show that we're serious," Cote says.

Because Congresshas patched the AMT every year since 1969, it's likely to do so again.Today, the AMT, originally intended to ensure the wealthy pay a minimumincome tax, usually hits taxpayers who have a household income over$75,000 and are married with more than two kids, according to BobMeighan, vice president at TurboTax. It would hit an estimated 28million for the first time if Congress doesn't act, raising their 2012tax bills by an average of $3,700.

A compromise deal would reducegrowth next year by as much as 1.5 percentage points, says Mark Zandi,chief economist at Moody's Analytics, but would hurt average taxpayersless than many people believe. The recovering economy is nearly ready topick up that slack, partly because of the improving housing market,rising consumer confidence and the effect that more certainty may haveon business investment, he says. Fast-expanding domestic oil and gassupplies are another tailwind that will help the economy, BlackRock vicechair Barbara Novick says.

"It's time," Zandi says. "Our economy is strong enough to digest the fiscal drag. If we lay out a path, the economy will jump."

Scenario 3

A safe landing

The least likely scenario is the opposite of going over the cliff:striking a "grand bargain" during the lame-duck Congress and outlininghow to get $3 trillion or more in deficit reduction over the nextdecade.

Fiscal watchdog groups have joined forces with corporateCEOs to encourage such a deal. The "Fix the Debt" campaign has raisedmore than $36 million, signed up more than 100 business leaders andbuilt bipartisan support for a balanced deal. More than 300,000Americans have signed its petitions.

But there are dangers toagreeing on too much, too soon. It could trigger a European-stylerecession, which could turn policymakers back toward stimulus spendingand tax cuts, such as those enacted in 2009.

One key to along-term deal: eliminating or at least reducing tax deductions andloopholes that cost the government billions. Targets include tax breaksfor oil and gas companies, and the wealthy, but some could affectmiddle-income taxpayers, such as breaks for home mortgage interest andemployer-paid health insurance.

"One of the prices to get tax reform is that people are going to have to pay more," Cote says.

Theother major part of any grand bargain would be changes to entitlementprograms, led by Medicare and Medicaid. Social Security is more likelyto be handled separately.

Republicans are looking for an eventualincrease in Medicare's retirement age from 65 to 67 and some form ofmeans-testing to collect more from higher-income seniors. Obama lastyear entertained changes in the Medicare retirement age during talkswith Boehner over raising the debt ceiling. Those talks failed, but theyform the basis of a new deal.

In an interview with USA TODAY,Boehner puts the problem in historical terms: "The next two years," hesays, "are going to be some of the most consequential we've had in 50 or60 years."